Master Limited Partnerships: Income From a Unique Structure and Industry

Kenny Feng is president and CEO of Alerian. I spoke with him about master limited partnerships and the Alerian MLP exchange-traded fund (AMLP), which is held in our Model ETF Portfolio.

—Charles Rotblut

Charles Rotblut (CR): Could you explain what a master limited partnership (MLP) is and how it differs from a traditional corporation?

Kenny Feng (KF): Sure. Energy master limited partnerships are engaged in four primary businesses, which are the exploration and production, transportation, storage and processing of natural resources and minerals. By confining themselves to these specific activities, MLPs are not subject to entity-level taxation as a traditional C-corporation would be. They are, however, subject to the same reporting requirements (annual reports, filing 10-Ks, filing 10-Qs, filing notices of material changes and complying with the Sarbanes-Oxley act) as publicly traded corporations. It is also worth mentioning that they trade on the public exchanges; about two-thirds of the energy MLPs trade on the New York Stock Exchange and a vast majority of the remaining one-third trade on the NASDAQ.

CR: And with their structure, the earnings flow through, correct?

KF: Exactly. They are pass-through entities.

CR: I know that creates different tax issues for investors than investing in a traditional corporation.

KF: Exactly. If you were to invest in IBM (IBM) or any other publicly traded corporation that pays a dividend, you would get a Form 1099, and you would report the payments as dividend income.

With MLPs, you are a limited partner, and you get distributions instead of dividends, as well as a proportional share of income and deductions. Your share of income, deductions, and any distributions appears on a Schedule K-1, which is the case for any other partnership in which you would own an interest. Due to the fact that MLPs incur various deductions for things like accelerated depreciation, roughly 70%–100% of the distribution is a tax-deferred return of capital.

CR: With respect to returned capital, one of the issues, particularly with retirement accounts, is that they can trigger the unrelated business income tax.

KF: When you put an MLP into a tax-deferred account (for example, an IRA), if you exceed a certain income limit, you do owe taxes on the excess amount. The limit is $1,000. The size of your ownership position determines whether or not you’re going to trigger that unrelated business income tax. But it does create issues for people who own MLPs in IRAs or other tax-deferred accounts.

CR: How are the revenues affected for MLPs involved in the pipeline industry? Pipeline fees are federally regulated, aren’t they?

KF: Pipelines and storage tanks, which are energy infrastructure assets, operate on what we call toll-road business models. If you’re driving on a tollway, regardless of whether you drive a Honda Civic or an Aston Martin, as long as it has four wheels, when you go through a toll booth, you’ll be charged the same tariff. In the same way, pipelines and storage tanks do not take title to the commodity itself. Over the past eight or nine years, we’ve seen oil prices move from $30 up to $150 and then back down to $40, and now we’re sitting in the $80–$100 range. Pipeline and storage tank businesses have not been directly exposed to those commodity price fluctuations because the way that they make money is a simple revenue equation of price times volume.

On the price side, you have an escalator indexed to inflation. It’s called a PPI (producer price index) adjustment. The PPI has moved from –1% in 1995, to +1.3%, to +2.65% today on all interstate oil pipelines. The upward adjustment over time is a function of the fact that the Federal Energy Regulatory Commission (FERC) understands that the financial viability of these companies is very important, as these assets represent the backbone of our nation’s energy infrastructure. It’s important to be able to recover not just the expenses that are built into operating pipelines and storage tanks, but also increased maintenance requirements over time.

On the volume side, energy demand growth for the United States has averaged roughly 1% per annum over the past 30 years. The consistency of that demand, with some mild fluctuations in between, has really been a function of the fact that President Eisenhower built up the U.S. highway system several decades ago. As a result, we’ve got suburbia: You’re driving your son to football practice, you’re driving your daughter to ballet practice, you’re driving to the grocery store. The consistency of gasoline demand has been largely inelastic over time. You still have to do those things, regardless of whether the economy is moving one way or the other. Due to the inelasticity of demand on the volume side and, again, the PPI escalator that kicks in every July 1 on the price side, we’ve got a revenue equation that is very predictable and, as a result, is able to pay consistent distributions.

CR: In terms of how the MLPs trade, what besides cash flow is influencing their prices?

KF: There are two sides to how MLPs trade. One is the fundamental side, obviously; the other is the technical side.

On the fundamental side, it really is the consistency of cash flows. MLPs have traditionally traded as a function of price to distributable cash flow. It’s important to note that distributable cash flow is net of maintenance capital expenditures. The price-earnings ratio, which is something that a lot of people use for other types of businesses, is not really useful for MLPs, because a lot of times the earnings themselves are going to be negative due to depreciation and other non-cash items. Cash flow is the number that matters, because that is what MLPs use to pay their distributions. Other than that, investors look at the spread to the 10-year U.S. Treasury note. It’s not our preferred metric for valuation, but it is something that people look at, and it is consequently important as far as behavioral finance is concerned.

On the technical side, the reality is that this is still an emerging asset class. MLPs have only been around since 1986. If you look at how many partnerships there are today, it is 75 companies and roughly $250 billion in market capitalization. That is essentially two-thirds the size of Exxon Mobil (XOM) by itself.

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Since MLPs are still an emerging asset class, they are going to be subject to growing pains. Some of the smaller partnerships are fairly illiquid, and the price volatility can be significant. We’re also seeing higher correlations to the broader equity markets as the asset class becomes more institutionalized. A lot of people like to think of these as bond substitutes, and while that may be true from a yield standpoint, it is worth noting that they can trade like equities, especially in downturns of the broader market.

CR: In terms of taxes, what is the difference between investing directly in a master limited partnership and investing in your fund?

KF: The first thing I would say is that if you can invest directly in an MLP, and you’re comfortable with the single-security risk and Schedule K-1 filings that come with investing in one, then do it. The reason is simply that there is greater tax efficiency in your distributions and you won’t pay any sort of management fee.

There are others who are looking to invest in a basket of securities, because that enables them to get diverse exposure through one vehicle. Similar to an MLP, the Alerian MLP ETF (AMLP) retains the underlying nature of the distributions, which is largely tax-deferred return of capital. You will get a 1099 (but no K-1s, and no state tax filings), in addition to the diversification benefits.

CR: To clarify: If someone buys Alerian MLP, they’re still going to get the tax benefit, meaning they can postpone paying taxes on the return of capital until they sell the ETF?

KF: Exactly. Alerian MLP has 25 securities in it, and they’re all midstream energy infrastructure names. Let’s say that if you were to own those 25 MLPs in individual accounts, the average tax-deferred portion of the return of capital would be 80%; the same would be true for owning Alerian MLP directly. The balance—that remaining 20%—would be a qualified dividend, which is another benefit of AMLP’s structure.

CR: If an investor buys the fund in a taxable account, when he sells it, he can actually use the distributions to reduce his basis?

KF: Right. Your basis comes down over time. You’re eventually going to pay the difference because it is tax-deferred, not tax-free. There is a deferral on that account, and you will end up paying taxes on that when you sell. It is this deferral mechanism that delays tax payments, which, thinking about the time value of money, benefits investors.

CR: What we’re talking about is actually reducing the taxable net profit reported to the IRS as a capital gain, correct?

KF: Right. In the current year.

CR: Is there anything else about MLPs that should be mentioned?

KF: One thing that comes up pretty often is, “How does this compare to other yield-oriented equities?” The most common comparisons are going to be to real estate investment trusts (REITs) and utilities, which have also been traditionally thought of as real income–generating equities.

Like MLPs, utilities benefit from inelastic energy demand. But the revenue mechanism for utilities is very different. Let’s say an electric utility goes to the local regulatory board and says, “I’d like to install electric meters at the homes of all my consumers.” (It’s a pretty big initiative that we’ve seen slowly moving across the entire country.) The utility presents its budget to the regulatory boards and says, “I’m going to have all these cost savings, and I need this amount of capital spending built in to my rate base.” The regulatory board comes back to the utility and says, “It’s a great idea, it’s going to generate a lot of savings, and now I’d like 50% of your savings for my consumers.” So you have a naturally antagonistic relationship that’s set up between the local regulatory board and the utility. The regulatory board’s job is designed to protect the consumer in a way that often becomes localized and politicized, unfortunately.

With MLPs, you don’t have that. Instead, you have overarching benign federal regulation that comes from the FERC on all interstate transportation of natural gas and crude oil. The benefit is that the process doesn’t get weighed down in some sort of bureaucracy that eventually becomes really unproductive for both service providers and consumers.

The other comparison that I mentioned is to REITs. A building has a permanent storage value that’s associated with it, because of the rent that it generates. We would argue that the pipelines that transport the natural gas to heat that building during the winter and to cool it during the summer have similar permanent storage or hard asset value.

The difference between REITs and MLPs is that during economic downturns, like the one we saw beginning in 2008, pipeline and storage MLPs don’t experience the same kind of cash flow volatility that REITs do.

The building that we used to be in was 90% occupied when we first moved in there in 2007. During the worst part of the economic crisis, it was 50% occupied. You could make the argument to your landlord, “Your building is at a much lower capacity than it was before; there are a number of other buildings that are also empty now, so I’m going to go and shop for the most competitive rate unless you give me a reduction in my rent.” Again, with MLPs, you don’t see nearly the same level of cash flow volatility to economic activity, because energy demand is pretty inelastic over time. That’s why the average MLP distribution growth was still 3%–5% per annum during each of the last three years, and it is on par for that again this year.

Discussion

John from WI posted over 3 years ago:

I've used an MLP investment as a place to store funds when I am not trading with a portion of my portfolio. I have experienced only positive results for the times I've used this strategy. Ownership has been limited to a two year tax period because of the extra forms required. Years I've used this:2001/2;2005/6; and 2010/2011. I do not use bonds in my trading account or ETFs.

Bedford from TN posted over 3 years ago:

MLPs are the best income vehicles. Especially from a tax perspective.
Linn Energy Is a LLC not a MLP but it has the same advantages,

Roger from TX posted over 3 years ago:

I have invested in MLPs in my taxable account since 2008. They provide a high level of current cashflow and many have raised their dividend rates frequently since my initial investment. Since most of the dividends are not taxable on a current basis, MLPs reduced my Fed Income Tax liabilities while I was working, and now that I am retired they reduce my Modified Adjusted Gross Income (MAGI) which is used to determine the adjustment to my Medicare premiums.

Tax programs like Turbotax are a big help and make it very easy to fill out IRS Sch K1 forms.

Also MLPs provide guidance for doing this.

Len from NE posted over 3 years ago:

maybe just me, but I thought this was confusing:
CR: If an investor buys the fund in a taxable account, when he sells it, he can actually use the distributions to reduce his basis?

KF: Right. Your basis comes down over time. You’re eventually going to pay the difference because it is tax-deferred, not tax-free. There is a deferral on that account, and you will end up paying taxes on that when you sell. It is this deferral mechanism that delays tax payments, which, thinking about the time value of money, benefits investors.

CR: What we’re talking about is actually reducing the taxable net profit reported to the IRS as a capital gain, correct?

KF: Right. In the current year.
CR seems to be under the impression that a reduction is basis is a good thing. It is not, it increases the capital gains that is subject to tax. So in the second question above, what we're talking about is actually increasing the taxable net profit reported to the IRS as capital gain. But the answer goes back to the effect on tax in the year a distribution is received not the effect on tax when the security is sold.
As a side issue, the fact that the gain can be permanently avoided if the security passes thru an estate or if the MLP is donated to a 501c3 should have been mentioned.

Bruce from ND posted over 3 years ago:

When I sold units in 2 MLPs (in 2010) part of the gain was ordinary income. The K-1s had work sheets which told me how much was ordinary and how to calculate the capital gain. However, I had suspended losses (from the same MLPs) carried over and was able to use them to offset the ordinary gain on sale (have to be from same MLP). I am not a tax advisor or CPA. The IRS instructions are confusing on this offset provision: Some CPAs appear to have interpreted that you have to sell all units of a given MLP to be able to use any of the suspended losses from that MLP. It appears to me that if you had a situation where you sold all units in a MLP and the suspended losses exceeded the ordinary gain on the sale, then you could use the remaining loss against other ordinary income. TurboTax basic did not handle this for me (had to override).

Belle from FL posted over 3 years ago:

I owned several MLPs--some for 5 or 6 years. I was overwhelmed with all the forms for reporting and sold the MLPs because I didin't like the filig mess. I made not only great interest (pass thru money) but also good capital gains as the MLPs kept going up in price. I'm thinking of trying again especially with something like AMLP

Thomas from WI posted over 3 years ago:

Could you or someone explain the result of holding AMLP in an IRA account, which I am doing now.

Dewey from TX posted over 3 years ago:

AMLP can be held in a retirement account as they pay requisite taxes prior to distribution of earnings to account holders. This practice may reduce your overall earnings but enables IRA ownership. I too hold AMLP in a retirement account.

Do MLP fund investors who are holders of multiple MLPs through an MLP fund receive a stepped up basis for tax purposes at the death of the holder, and if so, is this true of both privately and publicly held MLP funds?

John from AZ posted over 3 years ago:

If you hold several MLPs in an IRA and one reports a UBIT of $1100 and the other 2 report UBITs of -$500, can the totals be combined and avoid a taxable event?

William from AZ posted over 3 years ago:

I am a big believer in pipeline mlp's. They pay about 7%, and are backed by an asset that holds it's value. Also they will, over time, follow inflation thus maintaining their value. The market value will however vary with the stock market; over time though you come out ahead over bonds.

I believe that the increased cap gain taxes due to decreasing cost basis are not passed on to heirs. The cost basis is reset to the time of death. This feature is valuable to the elderly wishing to preserve value for surviving children.

The decrease in cost basis is due to the fact that you deducted depreciation from the partnership income. Your cost basis is reduced by the amount of the depreciation taken over time. It is possible that all your initial purchase will be depreciated. In that case your cost basis would be zero. I think that at that time you would no longer be able to take an income reduction due to depreciation, and the taxes on the distributions would be increased. This is complicated by the fact that depreciation allowed by the tax code is intricate. One fact is that the taxes can be deferred continually by depreciation resulting from continual replacement of depreciable assets.

The seller of an mlp is given a formula by the partnership for computing taxes; you plug in numbers and get a tax value. It would take a lot of curiosity to try to understand what happened.

It is also true that the taxes on distributions derived from the K-1 are mysterious. The only practical thing to do is to use Turbo-Tax or equivalent. You will never untangle the "map" provided with the K-1.

Robert from IL posted over 3 years ago:

What are the metrics that can be used to predict which MLPs will increse their distributions in the future? This is important for anyone holding them for a long period of time.

Dave from MN posted over 3 years ago:

Any capable accountant should be able to handle the tax reporting for any mlp. Plus the steady reliable income most of them provide is worth any extra tax prep effort. Most also come with easy to use directions and phone and online help for questions. Been using them now for a few years and have not had any problems. I think if you buy and hold them and collect the dividends thats great. If your going to use them to day trade, probably not such a good idea.

James from WI posted over 3 years ago:

Very good article, as well as discussion on tax implications. While I thought the information for the most part was very accurate, there are a couple of points I hold different opinions on. First as to MLPs receiving more "benign regulation" than utilities, I think this depends on the MLP. FERC has taken a much more aggresive stance in recent years, with several natural gas pipelines getting called in last year for "Section 5s" which are cases to consider if rates of return have been too high. They also tend to have large customers (producers, utilities) with the resources to challenge them if rates seem too high. A second item is that some MLPs that are midstream operators still have a fair amount of exposure to commodity prices, albeit not to the extent that E&P companies do. The exposure is typically from processing and refining. An example is that processing liquids from the natural gas stream is very profitable right now as the liquids prices track oil more than natural gas and the current spread between natural gas and oil is historically very high. There is no guaranty that this spread will hold. All this is not to say that MLPs are not great investments as I feel energy infrastructure in the US will be bullish for years to come. Howvever the MLP revenue mechanisms do get complicated, which is why I personally tend to favor MLPs with a proven track record. Regardless, thanks for the timely article about an asset class where earnings tend to hold up well even in an economic downturn.

Margaret from CO posted over 3 years ago:

I may have read all the comments above too quickly but for me the main problem with MLPs is not the K-1 report for federal taxes but the unexpected "surprise" of the non-resident state taxes you may need to report and pay. I find a search of the web sites of the various MLPs BEFORE investing are virutually silent as to what to expect when they send you the K-1 and accompanied exhibits. Seeking cousel of a tax advisors is expenseive!! Marg

Margaret from CO posted over 3 years ago:

I may have read all the comments above too quickly but for me the main problem with MLPs is not the K-1 report for federal taxes but the unexpected "surprise" of the non-resident state taxes you may need to report and pay. I find a search of the web sites of the various MLPs BEFORE investing are virutually silent as to what to expect when they send you the K-1 and accompanied exhibits. Seeking cousel of a tax advisors is expenseive!! Marg

John c from CO posted over 3 years ago:

The NAV of AMLP seems to consistently trail its index by 35 per cent the difference being the corporate tax rate paid as AMLP is actually a corporation and taxed as such.
The distributions of capital reduce the basis so the taxable gain is greater when sold unless inherited. There is a benefit from deferral but there is legislative risk from a change in tax code. Nevertheless the paperwork is less and the income return is steady. I would buy the stock if Mr Feng can confirm my understanding of the tax situation.

Terry from FL posted over 3 years ago:

I have held & increased my holdings in LINE (Linn Energy) for the past 3-4 years. It seems to have been a great investment, delivering consistent distributions, with good appreciation over time. My effective yield is probably 8-9% or more !!!

Carol from AR posted over 3 years ago:

I have invested in several MLP'S over the years. They are just like stocks in that there are good and bad ones. i like the pipelines but they
are pretty expensive right now.

J from PA posted over 3 years ago:

I started helping my parents prepare their income tax for their accountant. We found that he charges extra fees to calculate all the MLP's they had in their portfolio. The accountant informed them the size of their investments in each MLP was on the small size to make such investments profitable considering the extra charges. They were all less than $25,000. each. Something to check with your accountant.

Joe from NJ posted over 2 years ago:

I haven't had these tax problems, I guess because my MLP's are in a ROTH IRA???

Lester Smith from MI posted over 2 years ago:

Mlps are complex investments. It appears that AMLP has more advantages than most other MLPS and warrents more consideration for investment in most types of accounts.

B R from MS posted over 2 years ago:

I have done well with BPT over the years since 1993. Tax filing seems straight forward to me unless I'm missing something. The ultimate risk is when the well runs dry; otherwise, just the market price of oil. It will usually follow the price of oil; however, a few months ago, some goonie suggested that BP was going to quit paying the trust and Jim Cramer made a comment to sell into strength and guess what BPT dropped about 15% without merit in my opinon. Cramer and goonie do not know everything. Still holding on to BPT for the long haul.

Leon Taterus from PA posted over 2 years ago:

RE MLP TAX CONSIDERATIONS; YES IT CAN BE VEXING, BUT MY BROKERAGE FIRM, SCHWAB, REQUESTS I SEND THEM MY K-1s(WHICH USUALLY SHOW UP NEAR TAX FILING DEADLINE DATE). THEY THEN CALCULATE MY MLP TAXABLE REQUIREMENTS, AND IF NEED BE, THEY PAY IT OUT OF THE CASH IN MY ACCT.

Leon Taterus from PA posted over 2 years ago:

RE MLP TAX CONSIDERATIONS; YES IT CAN BE VEXING, BUT MY BROKERAGE FIRM, SCHWAB, REQUESTS I SEND THEM MY K-1s(WHICH USUALLY SHOW UP NEAR TAX FILING DEADLINE DATE). THEY THEN CALCULATE MY MLP TAXABLE REQUIREMENTS, AND IF NEED BE, THEY PAY IT OUT OF THE CASH IN MY ACCT.

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